Shopify & PayPal Q2 Earnings Reviews

Digesting the results of these e-commerce & payments players.

1. Shopify (SHOP) Q2 2023 Earnings Review

a. Demand

Beat revenue estimate by 4.3% & beat guidance by 4.3%.

GMV = Gross Merchandise Volume; GPV = Gross Payment Volume; MRR = Monthly Recurring Revenue

Demand Context:

• 22.3% 3-yr revenue CAGR vs. 41.8% Q/Q & 50.7% 2 quarters ago.

• Gross payment volume (GPV) = 58% of GMV vs. 53% Y/Y.

• Monthly recurring revenue (MRR) growth was helped by price hikes on standard plans which also led to Shopify Plus as a percent of MRR falling from 31% to 29% Y/Y. Churn from the hikes was very minimal.

• Social channel GMV rose nearly 100% Y/Y.

• Shop Pay crossed $100 billion in total GMV since launching in 2019.

• Ex-fulfillment (which was still a part of Shopify for part of this quarter) revenue growth was 28% Y/Y.

• Total take rate was 3.01% ex-fulfillment.

• Growth greatly outpaced industry benchmarks as it rapidly takes more share.

b. Profitability

• Beat EBIT estimate by 137% & beat guidance by 136%. Not a typo.

• More than tripled free cash flow (FCF) estimates with $97 million in FCF.

• Beat 48.9% gross margin (GPM) estimate by 100 bps.

Margin Context:

• GAAP EBIT was hit by a $1.6 billion charge from selling Shopify Fulfillment Network and severance. When these items roll-off, its GAAP operating income will be positive.

• Merchant solutions GPM gets diluted by rapid payments growth. Importantly, payments EBIT margin is similar to subscription EBIT margin due to less operating expense (OpEx) needs.

• Still had a full month of fulfillment business expenses this quarter and 2 full months of higher headcount which both continued to weigh on margins. That headwind is now gone.

  • Shopify realized about 2/3  of the OpEx benefits from cost rationalization and asset sale efforts this quarter. The remaining benefit will boost margins starting next quarter.

• Operating expenses fell 3.3% Y/Y and 10% Q/Q ex-one time charges from severance &  asset sales.

c. Guidance

• Beat 17.5% Y/Y revenue growth estimate by at least 350 bps. The low 20% range growth rate would be mid 20% ex-fulfillment. Strong.

• It expects to earn over $180 million in FCF next quarter which compares to estimates calling for $30 million. Strong again.

• Gross margin guidance of 51.3% was 80 bps ahead of estimates. Exiting fulfillment is propping this up by about 350 bps.

• OpEx to grow slightly Q/Q as its benefits from exiting fulfillment and lower headcount are being re-deployed to more aggressively market in its highest ad spend return areas and products.

d. Balance Sheet

• Share count rose 1.4% Y/Y.

• $4.8B in cash & equivalents.

• $914M in convertible notes.

• Shopify Capital at $719 million in receivables & cash advances.

e. Call & Release Highlights

Point of Sale:

The company integrated Shopify Installments (buy now, pay later) into the Shopify Point of Sale (PoS) suite. Customers using this pay later option in store are delivering a 5x boost to physical average order value. Point of Sale retailers with 20+ locations on the Shopify platform saw 120% Y/Y volume growth while the PoS sales team delivered a banner quarter for new merchant wins. Offline GMV overall rose 23% Y/Y. This success will lead to it accelerating marketing investments to support the product’s rapidly growing traction.

Shopify leadership covered a lot of the product announcements it revealed at Shopify Editions last week. Click here for a review of those launches.

Bigger Merchant Traction:

• Business to business sales channel volume rose 61% Y/Y over the first 6 months of 2023.

• Hydrogen and Oxygen is its headless build platform which separates back end from front end development to bolster customization for the largest customers. The platform crossed $1 billion in cumulative GMV.

• Shopify’s re-vamped enterprise sales approach is leading to record cross-selling volumes.

• Signed Meta Quest as a new Shopify Plus brand. Meta will launch a Shopify storefront and begin selling through multiple channels. Dollar Shave Club and more Nestle and Unilever brands were also named as new Plus wins.

Checkout & Payments:

• Shop Pay delivers 15% higher conversion on average. It’s the best converting checkout product in the World.

• Shop Pay presence lifts conversion rates by 5% when it’s a merchant site option.

Sign-In with Shop:

Shopify’s payments suite will offer Sign-in with Shop. This will free Shop App accounts to checkout on any Shopify merchant page with auto-filled data. This pins it more directly up against PayPal and open internet checkout options. 

Europe:

Strength in Europe surpassed any and all expectations from the team. It’s outperforming everyone else on the continent as GMV growth exceeds 40% Y/Y.

f. Takeaway

This was an elite quarter any way you want to look at it. It’s aggressively cutting costs while finding rapid demand acceleration. Find another company growing revenues at 30% Y/Y in this e-commerce environment while delivering inflecting free cash flow. You can’t. The free cash flow explosion has begun and it’s clear analysts have not come close to catching up to the pace of this ramp.

STILL, the company is extremely expensive. That is why I trimmed last month. Its gross profit multiple is more than double the market average. It deserves a hefty premium, but that feels a bit steep. I have no plans to sell any more shares, but would need a meaningful pullback to add to my stake. Wonderful performance. Two thumbs up and if I had a third that would be pointed up as well.

2. PayPal (PYPL) Q2 2023 Earnings Review

a. Demand

PayPal beat revenue estimates by 0.3% & beat guidance by 0.4%.

Demand Context:

• 19.2% 3-yr revenue CAGR vs. 23% Q/Q (easy comp) & 16.1% 2 quarters ago.

• The account decline is as expected as PayPal lets low engagement users roll off of the platform instead of throwing dollars after cash burning growth. This is part of its pivot from optimizing quantity to quality.

• Growth was hit by one-time revenue items in Q2 2022. Without this hit, Y/Y growth would have been 8.3%. One time items included $75 million from merchant compensation and $72 million less in Y/Y hedging gains as well as migrating small merchant private label customers to a new stack.

• Branded checkout volume rose mid single digits FXN Y/Y with acceleration throughout the quarter.

• Unbranded volume rose 30% Y/Y FXN. Braintree is killing it.

• Transaction revenue rose 5% Y/Y while value add service revenue rose 37% Y/Y due to higher customer balances.

• Take rate fell due to FX headwinds and also due to less currency hedge benefits which count as transaction revenue.

b. Margins

• Missed EBIT estimate by 2.5% & missed guidance by 2.5%.

• Met GAAP & non-GAAP EPS estimates & guidance.

Margin context:

• Free cash flow was hit by a $1.2 billion charge related to selling its BNPL receivables to KKR. When the sale closes, this cash flow hit will reverse entirely. That’s why PayPal reiterated its 2023 free cash flow guide.

• Cross border trade rose 3% Y/Y for 12% of total volume vs. 13% of total Q/Q. As this recovers, it will serve as a strong and needed transaction margin tailwind.

c. Guidance

Next quarter:

• Beat 7% Y/Y revenue growth estimates with an 8% Y/Y growth guide.

• Barely beat $1.22 EPS estimates by a penny.

Full year:

• Slightly raised GAAP EPS estimates.

• Reiterated EPS estimates calling for 20% Y/Y growth.

• Reiterated 100 bps of EBIT margin expansion Y/Y.

• Reiterated $5 billion in FCF.

• Non-transaction operating expenses to fall 10% Y/Y.

• Second half revenue growth to be the same or a bit better than the first half vs. previous guidance calling for growth to be the same. Small raise.

Growth will reach 10%-12% Y/Y by Q4.

d. Balance Sheet

• $1.5 billion in year to date buybacks. Diluted share count down 6% since 2021.

• $14.4 billion in cash & equivalents.

• $10.6 billion in debt.

e. Call & Release Highlights

Branded Checkout:

PayPal maintained branded checkout share delivering growth in line with the market. Its growth accelerated throughout the quarter and further in July to reach 8% Y/Y. This represents its highest monthly rate of growth since the pandemic. It sees branded checkout continuing to accelerate throughout 2023. As inflation cools, discretionary spend is accelerating which is helping to support this strength.

• BNPL growth accelerated further this quarter via the launch of pre-approved amounts.

• Passkeys have been rolled out to most PayPal users. 

• PayPal’s Net Promoter Score (NPS) is at 7 year highs as it modernizes its business.

• 43 of its largest 100 merchants are on its latest checkout flow vs. 30 Q/Q. PayPal continues to see branded share maintained or boosted for merchants on this flow vs. simply maintained for merchants not yet on it.

Transaction Margin:

The sore spot of the mostly positive report.

Braintree’s explosive growth continues to hit PayPal’s transaction margin. This is why transaction expense dollars rose 16% Y/Y and why transaction margin again contracted. While the headline numbers were quite good, the transaction margin of 45.9% is likely what is worrying investors… and rightfully so. This negative trend MUST revert by the end of the year or early 2024 for this investment to work. Otherwise the only long term profit growth this firm will deliver will be from cutting operating costs. 

The team sees transaction margin pressure continuing for Q3. Starting in Q4, it expects pressure to alleviate as expansion into value add services, smaller clients and other geographies fattens up its private label margins. Expansion into card-present use cases is also going very well which is margin accretive as well. This, along with accelerating e-commerce growth and recovering cross-border volumes should lead to margin tailwinds sooner than later which is necessary.

Lapping some Q2 2022 items also shaved several hundred basis points off of the 1% Y/Y growth in transaction margin dollars that it posted. Items include large FX hedging gains last year (which prop up transaction revenue). That will continue into Q3 and ease in Q4 as margin lever initiatives will materially kick-in. Transaction margin was also hit by migrating $5 billion in volume from its old small business stack to PPCP. That was a drag this quarter and won’t be next quarter.

A lot of headwinds are hitting this margin line. These headwinds should fade as we enter 2024.

“We will exit the year in a much stronger spot in terms of transaction margin than where we are now.” -- CFO Gabrielle Rabinovitch

“We understand that over the medium to long term, we need to deliver growth in our transaction margin dollars to ensure we sustainably grow our earnings. And we are beginning to see clear signs that our initiatives will yield notable traction against that objective over the next several quarters.” -- CEO Dan Schulman

More on Unbranded Checkout:

• Several large clients in late stage negotiations.

• “Couldn’t be more pleased” with the roll out of PayPal Commerce white label platform for smaller merchants. It already implemented Adobe, Shopify, Lightspeed and many more as channel selling partners.

• Clients like Meta and TikTok are adding value-add services in a sign that these margin levers are gaining traction.

• Braintree signed a deepening agreement with Booking.com to be its global processor. It also named Allstate as a customer.

Consumer Engagement & the Digital Wallet:

• PayPal’s newest cohorts are delivering notable improvements in engagement and lifetime value vs. older cohorts.

• Will debut an AI powered assistant this year to help users navigate all of the new products in the digital wallet app.

• Rewards members rose 20% Q/Q to pass 10 million. They transact on PayPal 32% more than non-users.

• Package tracking is rolled out to all accounts with a 10% lift in transactions for those using it.

CEO Change:

The team is in the “very final stages” of naming a new CEO. We personally cannot wait for them to be named as Schulman sounded half asleep on the call. He needs to retire.

Credit Quality:

PayPal’s business loan portfolio is starting to show signs of improving credit metrics following last quarter’s decision to tighten credit parameters. Provisions here were the sole source of the company’s EBIT miss as delinquencies crept up starting early this year. All other credit products are performing in line with expectations or better. This singular product, representing 15% of credit receivables, is lagging. Its guidance reiteration was despite this disappointment. It would've been raised without it.

Specifically:

• Credit losses rose 65% Y/Y while it built $146 million in provisions due to rising expected business loan losses.

• This is why the EBIT margin disappointed as well.

• Transaction loss rate improved from 0.116% to 0.08% Y/Y.

Venmo:

• Teen accounts are now live.

f. Takeaway

Headline numbers were fine but transaction margin was not good enough. It was supposed to contract again sequentially, but I was hoping for a more modest decline. Despite this company growing earnings by 20% Y/Y, despite it seeing branded checkout acceleration, despite its successful expansion into higher margin private label business and despite its fortress balance sheet and hefty buybacks, investors will focus on that metric.

Is that fair? Maybe not considering how strong the EBIT margin trajectory currently is. But it’s reality. PayPal can grow profits for a little while as this margin line tanks, but NEEDS it to bottom for long term profit compounding to realistically remain brisk. It’s hard to see sentiment turn sharply until that margin line bottoms like it should in Q4 and until Schulman is gone. Today, the unfair “dinosaur” narrative will likely remain as sentiment follows price action.

For now:

A company with THE leading branded checkout adoption, a Gen Z verb in Venmo and a rapidly growing white label processor the size of Adyen should not trade at PEG ratio well under 1x.

But here we are… and I truly believe it’s all in the transaction margin. I am pausing purchases on this name until I see it bottom. I still think the risk/reward is phenomenal here, but that uncertainty must be resolved before I deploy more capital. I have no interest in trimming my position. Frustrating investment thus far to say the least.